Inflation stickiness, demand, and judging the success of monetary policy

By Matt Nolan 30/01/2013

I am still a fan of flexible inflation targeting.  I agree with Nick Rowe that explicit inflation targeting has made inflation outcomes “stickier” – and that knowing inflation is in a range of the inflation target is therefore insufficient for telling if the central bank is truly achieving “socially optimal policy”.

For all the time I’ve spent reading monetary economics books and sitting in classes where macroeconomics has been discussed, I still remember a clear (albeit very partial) description of why we do inflation targeting that came in 100 level economics.

I distinctly remember my tutor saying that the point of inflation targeting in the form we use it in New Zealand was to pin down “inflation” (price growth that is shared between all goods and services that is independent of the “relative” value of these goods and services).  With people setting prices based on this view of inflation, central banks with a clear very of the economies “ability to produce” can move around “aggregate demand” in order to prevent recessions that are due to short-falls in demand.  The flipside was often that inflation stickiness was “asymmetric”, with excess demand translating into rising prices, while insufficient demand translated into falling output – this is our good friend the upward sloping, U-shaped, short run AS curve.

This story is massively oversimplified, especially in its treatment of expectations.  But an overarching goal of anchoring inflation expectations was always part of what central banks were aiming to do.  Given this, then in so far an central banks had an idea about economic capacity (which is a very debatable point in itself) they could help to manage “demand” in a macroeconomic sense.  When I was tutoring, this was very much how active monetary policy is taught to first years, and I doubt terribly much has changed.

And this is the point – economists have always know that, if their announcement of a 2% inflation target was the sole determinant of inflation, this does not mean “success” … it just means that they can focus solely more heavily on how the actions of monetary policy have a short-run impact on output.  Deviations of inflation from their target provide information that is useful information about the state of “demand”, but as the NGDP targeting proponents point out it does not capture the whole story.  Variables such as NGDP, and unemployment, provide significant information … something central bankers already recognise and incorporate, contrary to the “narrative” of them being closed minded (Nick isn’t saying this – I’m talking about the more general stories from the media).

This is consistent with flexible inflation targeting – and it does come with one massive hole.  Judging the “success of monetary policy”.  As of course, flexible inflation targeting can only be judged on a forecast, forecasts that are determined by the central banks themselves – and filled with unobservables such as “future economic capacity”.

NGDP targeting differs from this in only three ways:

  1. It changes a partially discretionary rule based process with a fully rule based process.
  2. It targets levels instead of growth rates – making policy “history dependent”.
  3. It gives guidance, and will make “stickier” growth in nominal income – compared to flexible inflation targeting which does this for price growth.

On that final point, at the moment inflation targeting lets a firm say “with competition and the such, I was able to increase my prices 2% this year – this is the same as inflation, and so in reality my “price” is the same”.  With NGDP targeting the firm will say “I increased revenues by 5% this year – this is the same as the growth in nominal spending/value add, as a result my real “revenue” is performing as well as the average firm”.  The right “guidance” will depend strongly on what we think is the most important factor for firms and households to have certainty about (to extract appropriate “market signals”).

To put all this another way – inflation stickiness isn’t an unintended consequence, it is a feature of central banks trying to improve the “sacrifice ratio” associated with active monetary policy!